Steve Hamilton is a Tampa native and a graduate of the University of South Florida and the University of Missouri. He now lives in northern Kentucky. A career CPA, Steve has extensive experience involving all aspects of tax practice, including sophisticated income tax planning and handling of tax controversy matters for closely-held businesses and high-income individuals.

Saturday, February 28, 2015

What Does It Take To Exclude Foreign Income?

At this
point of the tax season I usually lament not having won the lottery since last
year’s tax season. I would travel extensively, most likely overseas.

That would
put me out of the country, and you may have heard that there is a tax “break”
for people who work outside the country.I sincerely doubt it would apply to me in my imaginary lottery-fueled
world, but let’s talk about it.

If you work
overseas, you get to exclude up to $100,800 of earned income – such as salary –
from U.S. tax. This sounds like a great deal, and usually it is, but remember
that you would have been allowed a credit for income taxes paid the other country.
If the foreign taxes are the same or higher than the U.S. taxes, the effect of
the income exclusion is likely a push. If the other country has lower taxes
than the U.S., however, this could be a very sweet deal for you.

There are
ropes to claiming this exclusion. You have to meet one of two tests. The first
test is being outside the U.S. for at least 330 days during the year. Think
about this for a second. You take a job in Japan for a couple of years, but
your family stays in the U.S. This means that you can see them up to 35 days a
year – or forfeit the exclusion. I suppose they could travel to Japan instead,
but you get the idea.

There is a
second way, and that is to be a “bona fide” resident of the foreign country.
This is hard to do, as it means that your home is there and not here. “Home” in
this context does not just mean a place where you hang clothes and keep food in
the refrigerator. The tax Code wants more: it wants your “main” home to be
overseas.

Does this
happen much? You bet. Think an American expatriate – perhaps retired military
or someone who married overseas. I have family for example who have lived in
England for decades. They have gone to school, worked, married and raised children
there. They would easily qualify for the foreign income exclusion under the
bona fide test.

What if one
works overseas but still maintains ties to the U.S.? Can one also be a bona
fide citizen of another country?

You can
expect the IRS to be skeptical, especially if you leave a house or family behind.
This is the IRS equivalent of New York Department of Revenue not believing you
when you tell them you moved to Florida.

Let’s look
at one someone who recently tried to make the bona fide argument.

Joel Evans
took a job on Sakhalin Island in Russia, which has to count as going to the end
of the world. He was working the oil rigs, both on land and offshore. His
normal schedule was 30 days on followed by 30 days off. A 30- day stretch gave
him the flexibility to return frequently to the U.S.

He had a
house in Louisiana, and somewhere in there he got divorced. His daughter moved
into his house for a while. He returned to Louisiana whenever he could. He
eventually married a second time, and his wife moved into, and his daughter
moved out of, his house in Louisiana.

He claimed
the foreign income exclusion for years 2007 through 2010. The IRS said no and
wanted over $31,000 in back taxes from him

He had
absolutely no chance under test one, as he spent way more than 35 days annually
in the U.S. He argued instead that he was a bona fide resident of Russia.

I give him
credit, I really do. It was his only argument. He spent a lot of time in
Russia. He learned a little Russian. He fixed up a place to stay. He made
friends. He even dated some Russian women, which I presume he ceased doing when
he got remarried.

But that
isn’t the test, is it?

The test is
where his main home was. He pretty much gave his hand away when he kept
returning to Louisiana almost every thirty days.

The Tax
Court agreed with the IRS and disallowed his foreign income exclusion. He was
not a bona fide resident of Russia, and he could not exclude his foreign earned
income. He had failed both tests.

Let’s state
the obvious: he had no chance winning this one.

In my
practice, almost everyone relies on the 35-day test, and it is common to
monitor the 35 days like a hawk. I suppose if I were an expat (that is, living
overseas) preparing taxes for other expats, I would see the bona fide test more
frequently. There are not too many bona fides who would need my services in
Cincinnati.

Which rule –
the 35 day or the bona fide – would trip me up when I hit the lottery?

Neither. It
takes earned income – think self-employment or a salary – to power the foreign earned income exclusion. I have no
intention of working.

About Me

Thirty years years in tax practice. It's a long time, and I have seen virtually everything short of the fabled tax-exempt unicorn. I was raised in Tampa, went to school in Missouri, taught at Eastern Kentucky University, lived in Georgia, got pulled to Cincinnati when I married, have in-laws in England and a daughter going to the University of Tennessee. I am not sure where I will wind up next, but I hope there is better weather.